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What is a 'Business Model'

A business model is a company's plan for how it will generate revenues and make a profit. It explains what products or services the business plans to manufacture and market, and how it plans to do so, including what expenses it will incur.

BREAKING DOWN 'Business Model'

A business model lays out a step-by-step plan of action for profitably operating the business in a specific marketplace. The business model for a restaurant is significantly different from the business model for an online business for instance.

To put together a good business model, you need to know the value proposition for the business. A value proposition is a straightforward statement of what a company offers in the form of goods or services that is of value to potential customers or clients, ideally in a way that differentiates the company from its competitors. 

A business model should also include projected startup costs and sources of financing, the target customer base for the business, marketing strategy, competition, and projections of revenues and expenses. One of the most common mistakes leading to the failure of business startups is a failure to project the necessary expenses to fund the business to the point of profitability, i.e., the point in time when revenues exceed expenses.

If possible, a business model should include any possible plans for partnering with other existing businesses. An example of this would be an advertising business that aims to establish an arrangement for referrals to and from a printing company.

Types of Business Models

There are many different types of business models. Direct sales, franchising, advertising-based and brick-and-mortar are all traditional business models. Brought about by the internet, there is also a click-and-mortar business model, which combines a physical presence with an online presence. 

Even if two businesses operate within the same industry, they likely have different competitive advantages and disadvantages and, therefore, need different business models. 

Think about the shaving industry. Gillette is happy to sell its Mach3 razor handle at cost, or even lower, because the company can go on to sell you the profitable razor refills over and over. The business model rests on giving away the handle and making profits from a steady stream of high-margin razor blade sales. This type of business model is actually called the razor-razorblade model, but it can apply to companies in any business that sell one good at a discount while the second dependent good is sold at a considerably higher price.

Companies that sell electric shavers have a different business model. Remington, for example, makes most of its money up front on the sale of the razor rather than from a stream of blade refill sales.

Comparing Business Models

Successful businesses have developed business models that enable them to fulfill client needs at a competitive price and sustainable cost. Over time, circumstances change, and many businesses revise their business models frequently to reflect changing business environments and market demands.

Analysts use the metric gross profit as a way to compare the efficiency and effectiveness of business models. Gross profit is a company's total revenue minus the cost of goods sold. 

During the dotcom boom, analysts went in search of net income. They knew the internet was a disruptive technology with the ability to revolutionize certain industries, but where was the cash flow? When analysts couldn't find cash flow, they settled for the business model to legitimize the industry. Instead of looking at net income, calculated as gross profit minus operating expenses, analysts concentrated on gross profit alone. If the gross profit was high enough, analysts theorized, the cash flow would come. 

The two primary levers of a company's business model are pricing and costs. A company can raise prices and it can find inventory at reduced costs. Both actions increase gross profit. 

Gross profit is often considered the first line of profitability because it only considers costs, not expenses. It focuses strictly on the way in which a company does business, not the efficiency of management. Investors that focus on business models are leaving room for an ineffective management team and believe the best business models can run themselves.

As an example, assume there are two companies and both companies rent and sell movies. Prior to the internet, both companies made $5 million in revenues and the total cost of inventory sold was $4 million. Gross profit is calculated as $5 million minus $4 million, or $1 million. Gross profit margin is calculated as gross profit divided by revenues, or 20%.

After the advent of the internet, company B decides to offer movies online instead of renting or selling a physical copy. This change disrupts the business model in a positive way. The licensing fees do not change, but the cost of holding inventory is down considerably. In fact, the change reduces storage and distribution costs by $2 million. The new gross profit for the company is $5 million minus $2 million, or $3 million. The new gross profit margin is 60%.

Company B isn't making more in sales, but it figured out a way to revolutionize its business model, which greatly reduces costs. Managers at company B have an additional 40% in margin to play with while managers at company A have little room for error.

Assessing the Business Model

So, how do you know whether a business model is any good? That's a tricky question, but Joan Magretta, former editor of the Harvard Business Review, highlights two critical tests for sizing up business models. When business models don't work, she states, it's because they don't make sense and/or the numbers just don't add up to profits.

Because it includes companies that have suffered heavy losses in the past and even bankruptcy, the airline industry is a good place to find a business model that stopped making sense. For years, major carriers like American Airlines, Delta and Continental built their businesses around a "hub-and-spoke" structure, in which all flights routed through a handful of major airports. By ensuring that seats were filled, the business model produced big profits for airlines.

But the business model that was once a source of strength for the major carriers became a burden. It turned out that competitive carriers like Southwest and JetBlue could shuttle planes between smaller centers at a lower cost– in part because of lower labor costs, but also because they avoided some of the operational inefficiencies that occur in the hub-and-spoke model. 

As competitors drew away more customers, the old carriers were left to support their large, extended networks with fewer passengers– a condition made even worse when traffic began to fall in 2001. To fill seats, the airlines had to offer more and deeper discounts. No longer able to produce profits, the hub-and-spoke model no longer made sense.

For an example of a business model that failed the numbers test, we can look at U.S. automakers. In 2003, to compete against foreign manufacturers, Ford, Chrysler and General Motors offered customers such deep discounts and interest-free financing that they effectively sold vehicles for less than it cost to make them. That dynamic squeezed all the profits out of Ford's U.S. operations and threatened to do the same to Chrysler and GM. To remain viable, the big automakers had to revamp their business models.

When evaluating a company as a possible investment, learn exactly how it makes its money. Then think about how attractive and profitable that business model is. Admittedly, the business model doesn't tell you everything about a company's prospects, but investors with a business model frame of mind can make better sense of the financial data and business information.

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